This assignment is designed to give you a clear objective as you read
articles on current developments in the business press and a feel for the
uncertainty surrounding current and future economic conditions.

Provide forecasts for each of the following variables with a detailed
explanation following each number which explains how and why you chose the
number. At the end, summarize how your forecast on growth and inflation relates
to your forecast on Fed policy, long-term interest rates, the stock market and
the US $ exchange rates.

1. Real GDP growth for 2014 Quarters III and IV - SAAR (Seasonally Adjusted
Annual Rate). Provide also your forecast for real GDP growth in 2014 and 2015
(year over year growth rate) and explain the reasons behind your forecast and
for the difference in growth in 2015 versus 2014.

The advance data for 2014 Quarter III (IV) will be announced at the end of
October 2014 (January 2015). The latest estimates for the 2014 Quarter II
were 4.2% for GDP growth and 2.2% for the growth rate in the implicit GDP price
deflator (the GDP Price Index is in table 4 of the BEA GDP
Report).

3. a) When will the Fed favorite measure of
inflation (Core PCE inflation) reach persistently the Fed target of 2%? B) When
will the unemployment rate reach its NAIRU level and what is your best estimate
of NAIRU? C) How much slack is left in the labor market today?

4. a) Will the Fed change it forward guidance (considerable
time of 0% rates after end of QE and balance of labor market risks) regarding
the conditions that will lead to normalize the policy rate above 0% and how and
when (October FOMC meeting or later)? b) When will the Fed start normalizing
the policy rate (Fed Funds rate) above 0%? In 2014 or in 2015
or even later?In which month/quarter of which year?
c) In which year and quarter will the Fed finish normalizing the Fed Funds rate
to its neutral level and what will that neutral level be? d) When will the Fed
will start to run down its balance sheet by not reinvesting the maturing
Treasuries and RMBS that it has purchased during the various rounds of
quantitative easing?

5. The 10-year Treasury bond yield reported in the New York Times on
December 17th, 2014.

6. The S&P500 index of the stock market reported in the Wall Street
Journal on December 17th, 2014.

7. The exchange rate for the Japanese Yen (Yen per US Dollar) and the Euro
(US Dollar per Euro) reported in the Wall Street Journal on December 17th, 2014.

8. The exchange rate for the Chinese Yuan (Yuan per US Dollar) reported in
the Wall Street Journal on December 17th, 2014.

1. To defend or not defend? Exchange rate dilemmas in emerging
markets
Consider the uncovered interest parity condition modified for the case of a
country risk premium (in the case when investors are risk-averse):

it
=itf+ (E(St+1) -
St)/St + RPt

wherei is the domestic
interest rate (the interest rate in emerging market country Emergia),
if is the foreign interest
rate (the US interest rate), st is the
current spot exchange rate (Emergos per US Dollars)
and Et(st+1) is the expectation at time t of the
value of the exchange rate a period ahead (say one year). Solving the expression above for the current spot rate, we
can rewrite the expression as:

St = [E(St+1)] /
[ it - itf+ 1 - RPt]

(a) Suppose that initially: st =
Et(st+1) = 1 so that both the spot and expected future
exchange rate are equal to 1; domestic and foreign interest rates are equal to
5% so that i = 0.05 and if = 0.05; and there is no risk premium on
domestic assets so that RP=0. Would the spot exchange rate change over time if
nothing else changes? What would be the value of the
forward exchange rate at time t?

(b) Starting from the initial equilibrium, suppose that at time t investors
change their expectation of the future exchange rate and now believe that the
currency will be depreciated by 10% a year from now so that: Et(st+1)
= 1.10. Suppose that the country is in a regime of flexible exchange rates. By
how much will the current spot exchange rate (st) change following this change in
expectations? Explain also why.
Also, how will the forward exchange rate change following the change in
the expectation about the future exchange rate? (to
answer this last part of the question use the covered interest parity
condition).

(c) Now suppose that the country is committed to maintain the spot exchange
rate fixed to the initial parity (st = 1). Following the change in expectation about the
future exchange rate (described above in point (b)), by how much should the
domestic interest rate be changed by the domestic central bank in order to
prevent a devaluation of the domestic currency, i.e. maintain the fixed parity?
Explain why.
Also, how will the forward exchange rate change following the change in the
expectation about the future exchange rate and the interest rate reaction of
the central bank? (to answer this last part of the
question use the covered interest parity condition).

(d) Now suppose that you start again from the initial equilibrium (described
in (a) above). Suppose that investors change their view of the riskiness of the
domestic asset. They now start to believe that the domestic asset is more risky
than the foreign asset, maybe because of a risk of default of domestic assets.
Specifically suppose that the risk premium on domestic assets goes from zero to
7% so that nowRPt
= 0.07. Suppose that the country is in a regime of flexible exchange rates. By
how much will the current spot exchange rate (st) change following this change in
expectations? Explain why.

(e) Now suppose that the country is committed to maintain the spot exchange
rate fixed to the initial parity (st = 1). Following the change in the risk premium
(described above in point (d)), by how much should the domestic interest rate
be changed by the domestic central bank in order to prevent a devaluation of
the domestic currency? Explain why.

(f) Explain why the central bank may or may not be willing to change the
interest rate following the exogenous changes in expected future exchange rate
and/or risk premium described in points (b) and (d) above. First, suppose that
the central bank does not change interest rates and lets the spot exchange rate
be flexible and react to the shock to expectations (or risk premium); what
would be the effect of the movement of the exchange rate on the level of economic
activity (aggregate demand, trade balance, output and unemployment rate) and
inflation rate of the country? Suppose alternatively that the central
bank defends the fixed parity by changing interest rate: what would the
consequences of this change in interest rates on the level of economic activity
(aggregate demand, trade balance, output and unemployment rate) and inflation
rate of the country? Which tradeoff is the central bank facing in
deciding whether to let the currency float or defend instead the fixed
parity? How is this central bank dilemma (tradeoff) affected if the
country has a very large stock of foreign currency denominated external
liabilities (i.e. a large foreign debt in US $)? Why will the effect on
output of letting the exchange float be very different in the presence of a
large stock of foreign debt?

(g) Finally, consider the current yield curve (either in local currency or
in foreign currency) in an emerging market economy of your choice (in the fall
of 2014). Find the data and draw the yield curve for a country of your choice
(look in Bloomberg). Explain the reasons for the shape of the yield curve and
what the slope of the curve says about future levels of inflation, expectations
about exchange rates, sovereign risk and economic activity in the country.

2. Emerging Markets Slowdown and Financial Pressures in 2013: Risk of
Another Crisis?

In 2013-14 emerging market economies have experienced a significant
growth slowdown and downward financial pressures on their equity markets,
currencies and bonds (in local and foreign currency) that has been only partly
reversed since the second quarter of 2014.

(a)Discuss
in detail the role played in this slowdown and financial pressures by: the Fed
talk about tapering; the slowdown of China; the end of the commodity
super-cycle; the loosening of monetary and fiscal policy in the boom years; the
move away from market oriented reforms and towards state capitalism; the middle
income trap; the lack of second generation reforms; rising political risks in
many emerging markets; lack of decoupling from growth weakness in advanced
economies.

(b)Which
emerging market economies are most at risk and why? Which are the stronger
ones? Consider current account balances and their financing (via debt versus
equity, short versus longer term liabilities, foreign versus domestic currency
liabilities), fiscal balances and public debt, credit creation, savings and
investment, growth, inflation, social and political stability, upcoming
elections.

3. Are the US current account deficit and external debt sustainable?
(a). Make a chart of the U.S. current account deficit,
both in absolute $ value and as a share of GDP from 1990 to 2013. Find also the
most recent estimate of the U.S. current account deficit for 2014 (Q1 and Q2).

(b). For the same sample period (1990-2013), chart the evolution of the net
foreign assets of the U.S. (NIIP) and decompose the total NIPP in the part that
is the net stock of foreign direct investment from the part that is the rest
(portfolio, banks, other forms of debt).

(c). Discuss the evolution of the U.S current account deficit and net
foreign assets: how much of the evolution of the deficit (as a share of GDP) is
due to changes in private savings, public savings (fiscal deficits) and
investment rate (all as a share of GDP) and how much has the role of different
factors changed over time?

(d). Based on this analysis, are the U.S. current account and external debt
sustainable? Does the U.S. differ or not from emerging markets or not and why?

(e). How likely are the risks of a crash of the U.S. dollar triggered by
foreign investors reduced willingness to lend to the U.S. and accumulate U.S.
assets?

(f). Will the U.S. dollar strengthen or weaken in the next 2 years and
relative to which currencies and why?

Data for the U.S. current account, GDP and components of GDP are available
from the statistical tables in the Appendix of the 2013
Economic Report of the President. This web link also includes a link to the
statistical tables from the Appendix as spreadsheet
files (1997-forward):
To get exactly CA = S - I (apart from the statistical discrepancy), use the two
sheets of table B32 from this
source.where the Current Account is the Net Lending or Net
Borrowing column.

Note that both BEA and Economic Report of the President (ERP) give you data on
US savings and investment. However, the way they present the data on the current
account is slightly confusing; instead of referring to the current account,
they refer to Net Lending or Net Borrowing (implicitly from/to the rest of the
world). So, the item representing such Net Lending or Net Borrowing is the
current account.

For example in BEA Table 5.1 under the tab Savings and Investment by Sector http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&903=137
the Row 1 gives you gross savings. Row 21 gives you gross investment. Row
35 gives you the current account deficit, where the current account deficit is
the item that is defined (as I explained above) as Net Lending or Net Borrowing
(Row 35). Row 42 gives you the statistical discrepancy that should be added to Saving to have an item that is Savings (net of the
statistical discrepancy).
So, for example in 2011 Q1:

CA
=
S
- I
-489 = (2316.8 - 44.1)
- (2761.7)

where 2761.7 is the sum of gross domestic investment (2761.1) and the item
called "capital account transactions" (0.6), i.e. I or Investment is
the sum of lines 21 and 28 (Gross Domestic Investment plus Capital
Transactions).
What I called in class Capital Account is now called by BEA as the Financial
Account.
Note that the BEA and ERP data on S, I and CA differ because ERP was published
in February 2014 while the BEA numbers have been revised more recently.

Data on the net foreign assets of the United States can be obtained from the
table on the (Net) International Investment Position (NIIP) of the United
States published in the Survey of Current Business, Bureau of Economic
Analysis, U.S. Department of Commerce. A recent online version of the table for
2012 is available at: http://www.bea.gov/international/index.htm#iip
under "International Investment Position".

Assignment 3: The Mexican Peso Crisis of 1994-95

There has been a wide debate on the causes of the Mexican Peso crisis of 1994-95.
There are at least three competing (but not necessarily incompatible) views of
the causes of the crisis:

1. The "Unsustainable External Position" View.

According to this view a stabilization program under a regime of fixed
exchange rate and capital mobility leads a real exchange rate appreciation and
a worsening of the current account that becomes eventually unsustainable. The
real appreciation is caused by a number of factors: first, domestic price and
wage inflation is sluggish (subject to inertia) so that inflation falls slower
than the controlled rate of depreciation of the currency (or fixed exchange
rate if the crawl rate is close to zero). Second, an exchange rate based
stabilization leads to a fall in the real interest rate (r = i - dP/P) (as the nominal
interest rate - i.e. i -
falls faster than inflation - i.e. dP/P - once the
currency is pegged); this fall in the real interest rat
in turn leads to an expansion in aggregate demand and imports that causes
protracted current account deficits and a real exchange rate appreciation. Even though they are driven by private sector behavior (a fall in
private savings), rather than an inadequate fiscal position, the current
account deficit and the real appreciation can eventually become unsustainable.
Therefore, at some point a big real exchange rate
depreciation is needed to restore the initial level of competitiveness and
current account equilibrium.

2. The "Adverse Shock" View.

According to this view Mexico was subject to a large number of exogenous
domestic political and external economic shocks during 1994. It has been argued
that it was very difficult for the Mexican authorities to gauge the size or
anticipate the recurrent nature of these shocks. The Mexican authorities
reaction to the March events appeared to have restored a relative calm in the
foreign exchange and financial market until November. Therefore, it may well
have appeared reasonable to continue with the 1994 policy of sterilizing the
monetary impact of international reserve losses to offset the effects of what
were perceived to be temporary political and external shocks.

3. The "Policy Slippages" View.

According to this view the large number of adverse shocks that hit Mexico in
1994, added to the potential vulnerability stemming from weakness in the
external accounts, called for a much tighter monetary policy than the one
followed, and probably also for an early widening of the exchange rate
intervention band, so as to assure the markets that the authorities were fully
committed to sustaining the exchange rate regime. The failure to tighten
monetary policy and raise interest rate enough during 1994 seriously hurt the
credibility of the authorities' commitment to defend the exchange rate.

Discuss in detail the specific evidence in favor and against each of these
three views; in each case, provide data and reasoning supporting or criticizing
the alternative views. The "Factors Behind the
Financial Crisis in Mexico," and "Evolution of the Mexican Peso
Crisis," in your syllabus package are a good source of background
information, but you may want to add to it.